The recent financial problems experienced in the western world, and which arose from problems in sub-prime mortgage markets of USA has raised questions as to whether these could soon spread in DCs (Developing Countries).
To ascertain the extent to which this is likely, one has to appreciate the nature of financial systems and how these are so integrated that a fundamental problem in one financial market has a contagion effect on the others especially where such economies are strongly integrated as is the case with western economies which have strong economic ties especially by way of trade, and investments. To appreciate the magnitude of the problem, it is worth highlighting what has happened to such markets and its impact on real growth of economies affected.
Sub-prime mortgage markets, are mortgage markets to house owners whose credit worthiness may not meet the lending criteria of mainstream high street mortgage finance house. Thus, sub-prime loans are loans advanced to people with low, and or uncertain incomes. In case of USA, mortgagees were unable to repay their loans and therefore defaulted in large numbers. Such loans however, carry a risk premium over and above industrial averages of mortgage financial markets, to the extent that mortgage houses involved charge a high interest to borrowers in such markets to mitigate the risk exposure inherent in such financial undertaking.
Recent failures in such markets has meant that these borrowers failed to repay their loans to such a scale that exposed mortgage financial houses to illiquidity financial positions. Yet money lent by such houses belong either to other depositors and or shareholders. Failure to repay these loans therefore exposes financial institutions concerned so much that, they can not raise funds on financial markets. Since such companies may have raised funds on international financial markets from which they advanced sub-prime loans, means that many financial institutions are implicated and thus the contagion effect mentioned earlier.
In addition, the so-called sub-prime loans are discounted onto other banks and other financial institutions. It is therefore difficult to gauge the extent to which a number of banks and mortgage houses in western capitals are exposed to such losses. What is known for sure is that money lent to mortgagees is usually raised from depositors’ institutions especially pension and hedge funds, to the extent that any exposure leads to the recall of such loans. This in turn means that availability of credit is curtailed to such markets, which has ripple effect to entire economies. This effect arises out of the fact that the housing industry has a multiplier effect on the other sectors of the economy such as industries specializing in construction materials, construction companies themselves and their employees, and this feeds into the general consumer markets which are hit hard by a slack in this industry so much so that entire economies are affected in return.
Financial markets, however, are highly sensitive and very speculative that what happens in one market sends similar signals in the entire international financial markets and investors who are risk-averse will react accordingly by selling off financial instruments in institutions affected, and this then affects their ability of firms to raise credit thus the term credit crunch that has faced these markets. Since mortgage loans are not easy to recall, and where they are, costs and losses incurred can be prohibitive, means that, institutions involved face even more serious liquidity problems.
Generally, this scenario may effect the growth of an economy through contracted demand for housing which also affects firms producing building products and other associated firms. This then feeds into the entire economy through demand/supply cycles constraints and by extension slows down the economies affected.
The question is: will DCs face the consequences of the current financial problems experienced in western capital? The answer is yes, and no. Yes, for those DCs that are integrated to western markets through investments or trade, and the extent to which such integration is fundamental to such economies. Thus, for DCs that raise their funds on international financial markets frequently, it will be expensive, if not impossible to raise not only mortgage finance or sell any other forms of financial instruments to raise capital for their development.
Multinationals operating in such countries also may face similar credit crunch because more often than not raise funds through cross border/company borrowing which may be limited under these conditions. Where such multinationals are themselves financial institutions, the problem could even be more acute. No: because most of DCs financial markets are at their rudimentary stages of development such that, they hardly integrated with international financial markets. This is even more apparent considering that, foreign direct investments in such markets are insignificant and trade with such compared with their over all trade, irrelevant (as it is estimated to be approximately less than 10 per cent of entire world trade).
Nevertheless, The recognition of the causality relationship between financial development and economic development attracted the attention of researchers and policy-makers among the LDCs and those in Africa in particular, after the international financial crisis of the 1980s. This crisis shifted the attention of LDCs away from dependence on external financing for their development endeavours (which was at that time becoming scarce, and its timing unreliable). Since then many LDCs have attempted to mobilise their own domestic resources for their development. This inward looking approach (local savings mobilisation) to financing of development has served only to expose the inadequacy and inefficiency of their financial systems in financing their development agenda. A number have since returned to external financing, in the meantime re-organizing their financial systems by way of financial liberalisation and privatisation of their financial intermediaries.
Financial intermediaries can only mobilise and allocate resources efficiently if the following conditions hold:
(i) A system of firm and comprehensive financial regulation
(ii) A comprehensive and consistent policy of micro-economic framework that is conducive to high and stable incomes.
Whereas the first condition was put in place (at the insistence of IMF and the World Bank) as part of the structural adjustment programme (SAP), there is a problem of the nature of political will on most LDCs to uphold such regulations.
The second condition was, in most cases, circumvented for political expedience. This has put the financial systems of most LDCs under condition of fragility. According to Gillis, et al.(1992), policies for financial deepening should seek to promote the real size of the financial system and at the same time foster the growth of financial assets at a pace faster than the growth of real income. However, the idea that "finance leads growth" remains questionable, at least among LDCs and particularly in Africa, where substantial amounts of funds from multilateral and bilateral organisations, have not made any significant contribution to generating the continent’s growth and development. This seriously questions the role of finance in development in the absence of other factors such as human capital development, and requires re-examination of existing evidence in the relationship in the absence of other factors fundamental to growth and thus development..
The history of financial markets in African LDCs is that these financial systems were imposed on such economies (being imitations of capital markets from developed countries) without detailed regard for the socio-economic and cultural considerations of these developing economies. The result has been that such financial systems have not lived up to their expectations, and in some cases have collapsed with time.